Price Discovery in Agricultural Futures Markets: Should We Look Beyond the Best Bid-Ask Spread?

Price discovery is defined as the incorporation of information to prices through the actions of traders. Previous studies in financial markets have found evidence that informed traders may submit limit orders instead of market orders. If so, the steps of limit order book (LOB) beyond the best bid and best ask spread (BAS) contain valuable information and contribute to price discovery of the underlying asset. This is the first attempt to examine the informativeness of the LOB beyond the BAS for agricultural commodities. We reconstruct the LOB using market depth data and use three information share approaches to test whether the steps of LOB beyond the BAS contribute to price discovery in agricultural commodity markets. This is done for five major agricultural commodities namely live cattle, lean hogs, corn, wheat, and soybeans as well as the CME E-mini S&P 500. We find that a substantial market depth exists at the steps beyond the best bid and ask prices in the futures markets. The results of the three information share measures show that the steps of the LOB beyond the BAS contribute by over 27% to price discovery of futures contracts. Across agricultural commodities, the steps of the LOB beyond the BAS have more information for grains than meats. Moreover, we find that the steps closer to the top of the book, relative to the steps farther, contain more information. These findings suggest that informed traders in futures electronic markets actively use limit orders with price steps beyond the BAS and especially the steps near the top of the book. The results also show that for E-mini S&P 500, the steps closer to the top of the book contain more information at the beginning and the end of the week whereas steps farther have more information in the middle of the week.